The build up to the crisis global background

Low real interest rates stimulated borrowing and financial innovation

Long rates were low because of high saving especially by Asian
economies
Short rates were held low in the US
Buildup of debt and asset price boom
New features of the market were not stress tested for downturns
New asset backed securities hid risk rather than shared or
reduced it
Reliance on wholesale markets was unwise

26

The build up to the US crisis

Structural background:
Rush to sub prime lending in US, encouraged by government and
compensation schemes for bankers
Accelerating shift to securitisation, credit assessment neglected
for CDOs and other ABS
Low levels of liquidity and aggressive liability management by
banks
Some ABS held in SIVs and conduits, ABCP financed (Basel 1)
Context of global liquidity glut and search for yield (sub-prime and
ABS)
Suspicion of disaster myopia

27

The Structure of the Financial System

Indirect Finance
Financial Intermediaries
Banks and other monetary institutions
Insurance companies and pension
funds
Other financial intermediaries

Money savers
1.
2.
3.
4.

Households
Companies
Government
Central Bank

Financial Markets
Money Markets
Debt Markets
Equities Markets

Money spenders
1.
2.
3.

Companies
Government
Households

Direct Finance

The lenders may supply funds either by Financial Markets or

Financial Intermediaries.

34

The Structure of Financial Markets

Financial Markets are the institutions through which a person (or an

institution) who wants to save can directly supply funds to a person (or an
institution) who wants to borrow. There are several categorization of
financial markets:
(i) Debt and Equity Markets
(ii) Primary and Secondary Markets
(iii) Exchanges and Over-the-Counter Markets
(iv) Money and Capital Markets
(v) Foreign Exchange Markets

35

Classifications of Financial Markets

1. Debt Markets
Short-term (maturity < 1 year) Money Market
Long-term (maturity > 1 year) Capital Market
2. Equity Markets
Common stocks
3. Primary Market
New security issues sold to initial buyers
4. Secondary Market
Securities previously issued are bought and sold
5. Exchanges
Trades conducted in central locations (e.g., Toronto Stock Exchange and New
York Stock Exchange)
6. Over-the-Counter Markets
Dealers at different locations buy and sell
36

Characteristics of Debt Markets Instruments

Debt instruments:
- Buyers of debt instruments are suppliers (of capital) to the firm, not
owners of the firm
- Debt instruments have a finite life or maturity date
- Advantage is that the debt instrument is a contractual promise to pay
with legal rights to enforce repayment
- Disadvantage is that return/profit is fixed or limited
- An interest rate is the cost of borrowing or the price paid for the rental of
funds

37

Debt Instruments - Money Market Instruments

Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements (RPs) and Reverse RPs
Federal Funds
LIBOR

39

Valuation of debt instruments Yield to Maturity

The interest rate that equates the present value of cash flow
payments received from a debt instrument with
its value today
YIELD TO MATURITY IS THE MOST ACCURATE MEASURE OF
INTEREST RATES

41

Coupon Bond

Using the same strategy used for the fixed-payment loan:

P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C
C
C
C
F
P=
+
+
+. . . +
+
2
3
n
1+i (1+i ) (1+i )
(1+i ) (1+i ) n
43

Yields to Maturity on a 10%-Coupon-Rate Bond Maturing in

Ten Years (Face Value = $1,000)

When the coupon bond is priced at its face value, the yield to
maturity equals the coupon rate
The price of a coupon bond and the yield to maturity are negatively
related
The yield to maturity is greater than the coupon rate when the bond
price is below its face value
44

Consol or Perpetuity
A bond with no maturity date that does not repay principal but
pays fixed coupon payments forever

P = C / ic
Pc = price of the consol
C = yearly interest payment
ic = yield to maturity of the consol

can rewrite above equation as this : ic = C / Pc

For coupon bonds, this equation gives the current yield, an
easy to calculate approximation to the yield to maturity
45

Discount Bond
For any one year discount bond
F-P
i=
P
F = Face value of the discount bond
P = current price of the discount bond
The yield to maturity equals the increase
in price over the year divided by the initial price.
As with a coupon bond, the yield to maturity is
negatively related to the current bond price.
46

Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
Pt +1 - Pt
C
+
RET =
Pt
Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt +1 - Pt
= rate of capital gain = g
Pt
47

Rate of Return and Interest Rates

The return equals the yield to maturity only if the holding

period equals the time to maturity
A rise in interest rates is associated with a fall in bond prices,
resulting in a capital loss if time to maturity is longer than the
holding period
The more distant a bonds maturity, the greater the size of the
percentage price change associated with an interest-rate
change

48

Rate of Return and Interest Rates (contd)

The more distant a bonds maturity, the lower the rate of

return that occurs as a result of an increase in the interest rate
Even if a bond has a substantial initial interest rate, its return
can be negative if interest rates rise

49

Rate of Return and Interest Rates (contd)

At first it frequently puzzles students that a rise in interest rates

can mean that a bond has been a poor investment.
The trick to understand it is to recognize that a rise in the interest
rates means that the price of a bond has fallen.
A rise in interest rates therefore means that a capital loss has
occurred, and if this loss is large enough, the bond can be a poor
investment indeed.
Lets look..

50

One-Year Returns on Different-Maturity 10%-Coupon-Rate

Bonds When Interest Rates Rise from 10% to 20%

51

Interest-Rate Risk

Prices and returns for long-term bonds are more volatile than
those for shorter-term bonds
There is no interest-rate risk for any bond whose time to
maturity matches the holding period

52

Example

Which $1,000 bond has the higher yield to maturity, a 20-year

bond selling for $800 with a current yield of 15% or a one
year bond selling for $800 with a current yield of 5%?

53

Characteristics of Equity Markets Instruments

Equity instruments (common stock is most prevalent equity

instrument):
- Buyers of common stock are owners of the firm
- Common stock has no finite life or maturity date
- Advantage of common stock is potential high income since
return is not fixed or limited
- Disadvantage is that debt payments must be made before
equity payments can be made

54

The Stock Market

Common stock represents a share of ownership in a

corporation
A share of stock is a claim on the earnings and assets of
the corporation

55

Capital Market - Equity

Common stock
- Residual claim
- Limited liability

Preferred stock
- Fixed dividends - limited
- Priority over common
- Tax treatment

56

One-Period Valuation Model

Div1
P1
+
P0 =
(1 + ke ) (1 + ke )
P0 = the current price of the stock
Div1 = the dividend paid at the end of year 1
ke = the required return on investment in equity
P1 = the sale price of the stock at the end of the first period

57

Generalized Dividend - Valuation Model

The value of stock today is the present value of all future cash flows
Dn
Pn
D1
D2
P0 =
+
+ ... +
+
1
2
n
(1 + ke ) (1 + ke )
(1 + ke ) (1 + ke )n
If Pn is far in the future, it will not affect P0

Dt
P0 =
t
(1
+
k
)
t =1
e
The price of the stock is determined only by the present value of
the future dividend stream

58

Gordon Growth Model

P0 =

D0 (1+ g)
D1
=
(ke g) (ke g)

D0 = the most recent dividend paid

g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate forever
The growth rate is assumed to be less than the required return on equity

60

Rate of Return
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
P - Pt
C
RET =
+ t +1
Pt
Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt +1 - Pt
= rate of capital gain = g
Pt
61

Primary and Secondary Market

Primary Markets: the new issues of stocks, bonds or other seucrities

typically marketed to the public by investment bankers
IPOs and seasoned new issues
in the case of bonds, a public offering and a private
placement refers to the issue that usually is sold to one or
a few institutional investors and is generally held to
maturity
Secondary Market: trading of already-issued securities among
investors. Trading in the secondary markets does not affect the
outstanding amount of securities; the ownership is usually transferred
from one investor to another.
63

The Foreign Exchange Market

The foreign exchange market is where funds are converted

from one currency into another
The foreign exchange rate is the price of one currency in terms
of another currency
The foreign exchange market determines the foreign exchange
rate

65

Over-the counter market

Dealers at different locations who have an inventory of securities stand

ready to buy and sell securities over the counter to anyone who
comes to them and is willing to accept their prices
Because over-the-counter dealers are in computer contact and know
the prices set by one another the OTC market is very competitive and
not very different from a market with an organized exchange
Many common stocks are traded OTC but a majority of the largest
corporations have their shares traded at organized stock exchanges
such as New York Stock Exchange

66

Internationalization of Financial Markets (Glossary)

Foreign Bonds: sold in a foreign country and denominated in that
countrys currency
Eurobond: bond denominated in a currency other than that of the
country in which it is sold
Eurocurrencies: foreign currencies deposited in banks outside the
home country
Eurodollars: U.S. dollars deposited in foreign banks outside the
U.S. or in foreign branches of U.S. banks
World Stock Markets
Help finance federal government also (role of Japan)

67

The Structure of the Financial System

Indirect Finance
Financial Intermediaries
Banks and other monetary institutions
Insurance companies and pension
funds
Other financial intermediaries

Money savers
1.
2.
3.
4.

Households
Companies
Government
Central Bank

Financial Markets
Money Markets
Debt Markets
Equities Markets

Money spenders
1.
2.
3.

Companies
Government
Households

Direct Finance

The lenders may supply funds either by Financial Markets or

Financial Intermediaries.

68

Financial Intermediaries

Financial intermediaries are financial institutions through which savers can

directly provide funds to the borrowers. The word intermediary reflects the role of
these institutions in standing between savers and borrowers.

Generally one distinguishes two types of financial intermediaries: banks and

non-bank financial intermediaries. The latter can be divided into formal and
informal.

The non-financial intermediaries include:

Insurance companies
Pension funds
Mutual Funds
NGOs
Money Transfer Agencies

Over the past several decades, the non-bank financial institutions have become
important players in financing business.
69

Why do we need financial intermediaries?

71

Adverse Selection and Moral Hazard: Assymetric

information
Adverse Selection:
Before transaction occurs
Potential borrowers most likely to produce adverse outcomes are ones most likely
to seek loans and be selected
Example:

Moral Hazard:
After transaction occurs
Hazard that borrower has incentives to engage in undesirable (immoral) activities
making it more likely that wont pay loan back
Example:
72

Example Assymetric Information

A risk neutral enterpreneuer considers founding a private limited company (limited liability in GB). The new
company can undertake one of the following projects (or pursue one of the following strategies), which are
characterised by uncertain pay-offs in the two (equally likely) states of the world after one year.
States
Probabilities
Investment 1
Investment 2

1
0,5
80,000
200,000

2
0,5
180,000
40,000

Total value
130,000
120,000

Both projects require an investment of 90,000 EUR in t=0. To keep things simple, assume that all people are risk
neutral and the risk-free interest rate is 0. The problem here is that of assymetrical information and incentives to
hurt the other party. Potential providers of capital cannot observe and therefore not enforce by legal means
which project the enterprenuer finally implements. But they are clevel enough to understand that they are
exposed to the danger of moral hazard.
a) Which project should/would the enterprenuer undertake if he were to provide all of the require funding by
herself or if she could effectively commit herself to invest in the project which she promises to others.
b) Now assume that the entreprenuer looks for a loan to fully finance her preferred investment project. The
enterprenuer does not have any money. Which repayment would a bank request to receive (and thus at the
same time: what would bet he agreed nominal interest rate on a loan of 90,000 EUR) provided that:
i) the enterprenuer/borrower can make a credible and binding commitment concerning her
investment choice
ii) the enteprenuer/borrower cannot make a credible and binding commtiment which project she
selects. Please explain why commitment is important in this specific case. What might motivate
the borrower not to select the seeminlgy efficient alternative?
73

Reducing the Adverse Selection and Moral Hazard

Problems
Solving Asymmetric Information Problems
1. Screening
2. Monitoring and Enforcement of Restrictive Covenants
3. Specialize in Lending
4. Establish Long-Term Customer Relationships
5. Loan Commitment Arrangements
6. Collateral and Compensating Balances
7. Credit Rationing

74

Transaction Costs and Financial Structure

Transaction costs hinder flow of funds to people with productive
investment opportunities

Example:
Say you have 5,000 you would like to invest, and you think about investing in the stock
market. Because you have only 5,000 you can buy only a small number of shares. The
stockbroker tells you that your purchase is so small that the brokerage commission for
buying the stock you picked will be large percentage of the purchase price of shares. If
instead you decide to buy a bond, the problem is even worse. Indeed, the broker may
not be interested in your business at all, because the small size of your account does
not make spending time on it worthwhile. You are disappointed and realize that you
will not be able to use financial markets to earn a return on your hard-earned savings.
You can take some consolation, however, in fact you are not alone in being stymied by
high transaction costs. This is a fact of life of many of us: only around on-half of
American households own any securities.
75

Transaction Costs and Financial Structure

Transaction costs hinder flow of funds to people with productive investment
opportunities

Financial intermediaries make profits by reducing the transaction costs:

1. Take advantage of economies of scale
Example: Mutual Funds
2. Develop expertise to lower transaction costs

76

What is the role of Financial Intermediaries in a

Financial System?

Mobilization of funds and converting the unproductive and illiquid savings into the
productive investments thanks to information unavailable to private and public markets
Delegated monitoring thanks to monitoring of financing firm, the financial
intermediaries are able to ensure that the distributed funds are allocated with the aim of
its destination
Corporate control through the ability of monitoring borrowers, the financial
intermediaries allow the economy to overcome moral hazard problems and reduce the
agency costs
Risk-sharing banks, mutual funds and other financial intermediaries all provide useful
vehicle for pooling, trading and risk-diversifying leading to the shift of investors portfolios
towards more uncertain but higher return
Intertemporal risk-smoothing as long-lived institutions, they may facilitate
intergenerational risk arising from investing in the long-run projects offering relatively low
returns in the boom times and high in the slack times.

77

Adverse Selection and Financial Structure

Lemons Problem in the Securities Markets

If cant distinguish between good and bad securities, willing to pay only
average of good and bad securities values.
Result: Good securities undervalued and firms wont issue them; bad
securities overvalued, so too many issued.
Investors wont want to buy bad securities, so market wont function well.
Less asymmetric information for well known firms, so smaller lemons
problem

78

Tools to Help Solve Adverse Selection (Lemons)

Problem
Private Production and Sale of Information
Free-rider problem interferes with this solution
Government Regulation to Increase Information
Financial Intermediation
A. Analogy to solution to lemons problem provided by used-car
dealers
B. Avoid free-rider problem by making private loans
Collateral and Net Worth

80

Moral Hazard: Debt versus Equity

Moral Hazard in Equity: Principal-Agent Problem

1. Result of separation of ownership by stockholders (principals) from control
by managers (agents)
2. Managers act in own rather than stockholders interest

1.
2.
3.
4.

Tools to Help Solve the Principal-Agent Problem

Monitoring: production of information
Government regulation to increase information
Financial intermediation
Debt contracts
81

Moral Hazard and Debt Markets

Moral hazard: borrower wants to take on too much risk

Tools to Help Solve Moral Hazard

1. Net worth
2. Monitoring and enforcement of restrictive covenants
3. Financial intermediation - Banks and other intermediaries have
special advantages in monitoring

82

Summary: Asymmetric Information Problems and Tools

to Solve Them

83

Importance of the Financial Systems

Imagine yourself taking a business-school exam in international financial

management. The test is a case study. It concerns Opacia, an emerging
economy which is in a bit of a mess. Corporate financial statements mean
little as firms routinely lend to each other off balance sheet. You have no
idea how big the countrys foreing liabilities are, though you know that its
banks and companies like to borrow dollars short-term, usually finance
long-term local investment projects. There is no effective bankruptcy law,
and corruption is rife.
Is it a safe place to invest money?

84

What do you need in order to sleep well after having invested your
money in Opania?
Would you invest there at all?

1. legal system
2. accounting standards
3. government credit (directs)
4. financial institutions (not nationalized)
5. adequate government regulation

85

Financial Sector and Financial

System
the difference?

86

The Structure of the Financial System

Indirect Finance
Financial Intermediaries
Banks and other monetary institutions
Insurance companies and pension
funds
Other financial intermediaries

Money savers
1.
2.
3.
4.

Households
Companies
Government
Central Bank

Financial Markets
Money Markets
Debt Markets
Equities Markets

Money spenders
1.
2.
3.

Companies
Government
Households

Direct Finance

The lenders may supply funds either by Financial Markets or

Financial Intermediaries.

87

 and to meaningful definitions and distinctions

The Financial Sector
Encompasses the totality of institutions which specialize in providing financial
services to the non-financial sector units in the economy - i.e. banks, NBFIs,
organised markets; and the relevant regulating and supervising bodies - and their
rules, structure and behaviour.
The Financial System
Encompasses the demand for, and the supply of, financial services, and thus, of
course also the "professional providers", i.e. the financial sector, and the interplay
between demand and supply.
Thus the Financial System is more than the Financial Sector
In addition to the financial sector and to the demand for its services, it also includes
the extent to which the financial sector does not meet the demand of the nonfinancial sector units and forces them to self-finance, self-invest and self-insure.
88

Financial systems are commonly classified

as being bank- based or capital market- based
Bank-based financial
system

Capital-based financial
system

Banks play the dominant role

Capital markets are main sources of

financing for firms and serve households

Banks are the main providers of financing

for firms

Bank leding is restricted in terms of

volume and maturities

Banks are the most important deposit

takers
Bank-client relationships with firms are
close; most firms have their house - banks
Banks play an important role in the
governance of non-financial firms
Banks are organised as true universal
banks and they dominate the entire
financial sector
Corporate governance regime is
stakeholder-orientated
Stock markets unimportant

Bank-client relationships is rather at

arms length
Banks are often specialized either by law
or by tradition
Non-financial intermediaries play
important role
Investor information and investor protection is very important
Control of management through market
forces -market for corporate control
Corporate governance is shareholder
oriented

93

It is a challenge for empirical research to determine

whether the growth impact of a financial system
depends on its quality
Open Ends

Bank-based

Capital-based

Financial Systems

Financial Systems

?
Banks and stocks markets have independent effects on growth as they provide different financial services
(Levine and Zervos, 1998)
There may be a positive relationship between different measures of financial sector size, but the type of the
system does not seem to matter (Levine, 1999)
It would be important to better measure financial sector quality. Looking at its internal consistency might
provide an answer to this question

94

The possible convergence of financial systems either

towards a middle groundor to the Anglo-Saxon
model is a highly controversial topic

U.S.

Germany

Bank-based
Financial Systems

Japan

France

Capital-based
Financial Systems

U.K.

95

Financial System and Economic Growth

Recent research has found than an important reason why many

developing countries or ex-communist countries like Russia,
(which are referred to as transition countries) experience very
low rates of growth is that their financial systems are
underdeveloped (a situation referred to as financial repression).
The economic analysis of financial structure helps to explain how
an underdeveloped financial system leads to a low state of
economic development and economic growth.
(World Bank, Finance for Growth: Policy Choices in a Volatile
World)

96

Financial System and Economic Growth

Central Questions

Do countries with better developed banks and financial markets

enjoy substantially greater economic success?
Does this translate in higher capital accumulation or productivity
growth?
Why do not all countries take advantage of this?

97

Alternative Views
Economists hold startlingly different views about the impact of finance on
long-run economic growth?
Finance promotes growth (Hamilton-Schmupeter):
banks are the happiest engines that ever were invented for creating
economic growth
Finance hurts growth (Adams):
banks have done more harm to the mortality, tranquility, and even
wealth of this nation than they have done or ever will do good
Finance follows growth (Robinson)
Finance doesnt matter (Solow growth accounting):
growth is mainly due to technological progress, leaving little role for
finance

98

Financial sector and resource allocation

Fund Providers

Investment
Proposals

Potential
Investors

Financial Sector:
Resource Allocator

Resource
Deprivation
Investment
Failure
Bad loan

Inefficient Allocation

Production

Land
Labor
Equipment

Case
approved

Resource Acquisition/Allocation

Efficient Allocation
99

Finance promotes growth - Theory

Financial Functions
- pooling resources, subdividing shares
- transferring resources across time and space
- managing risk
- generating and providing information
- resolving competing claims on wealth generated

Channels to Growth
- capital accumulation, physical and human
- technological innovation

GROWTH
100

Finance promotes growth - Theory

That
is to say that countries whose financial systems
perform their functions better, grow faster.

101

The "quality" - or the state of development of the financial

system/sector matters for the growth and development of a country
Empirical debate

Positive real interest rate

Moderately negative real interest rates (0 to 5%)
Strongly negative real interest rates (less than 5%)

Starting with Bagehot, it has

always been clear to
economists that finance is
important
But this knowledge has been
discarded by the neo-classical
theory of economic growth
It only came back with the
theory of endogenous
growth (Romer, Lucas)
A start of empirical work was
made in the WDR of 1989
In 1993, King and Levine
empirically confirmed
Schumpeters view that:
finance matters

102

The legal system a country relies upon has a significant

influence on economic growth

The protection of shareholders and creditors by the legal system helps explain the
patterns of corporate finance in different countries:
breadth and depth of capital markets
pace of new security issues
corporate ownership structure
dividend policy
efficiency of investment allocation

Investor protection is crucial:

expropriation of minority shareholders and creditors in many countries is
extensive
outside investors face a risk that the returns on their investments will never
materialize because the managers or controlling shareholders may expropriate
them (insiders)
103

e(Growth in Gini Coe

oefficient |
X)

Inequality declines as finance develops

e(Private Credit | X)
Residuals
Values

Fitted

104

Why does a financial structure of a country

matter?
There are at least three reasons why the financial struture is important:

Efficiency in terms of our previous figure, the issue is how effectively funds flow from borrowers to
lenders so that everbodys wealth is maximized.
(a) how financial system allows risk to be shared and who bears that risk
(b) incentives to produce and use information; in particular,where the resources can
be most profitably invested.
(c) how effective is corporate governance implemented?
(d) how financial sytstem evolves over time and the role of law and politics in
determining it.

Financial Stability what is the relationship between the struture of the financial system and the
banking crises, currency crises, asset-price bubbles and crashes, contagion and financial fragility.

Monetary Policy Transmission Channels two views:

(a) money view- interest rates affect consumption and investment as predicted by
neoclassical theories based on perfect capital markets. Institutions do not matter!
(b) credit view with the imperfect capital markets, the effects of monetary policy
transmission depends on access to finance. How finance is obtained by firms,
houeseholds, and governments depends on the financial structure.
105